1. Introduction

An economy needs energy to produce goods and deliver services and
the size of an economy is highly correlated with how much energy
it uses (Brown et al., 2010a, Warr and Ayers, 2010). Oil has been
a key element of the growing economy. Since 1845, oil production
has increased from virtually nothing to approximately 86 million
barrels per day (Mb/d) today (IEA, 2010), which has permitted
living standards to increase around the world. In 2004 oil
production growth stopped while energy hungry and growing
countries like China and India continued increasing their demand.
A global price spike was the result, which was closely followed
by a price crash. Since 2004 world oil production has remained
within 5% of its peak despite historically high prices (see
Figure 1).

Figure 1. Oil production stopped growing
in 2004 while demand continued to increase. The result was a global
oil price spike that contributed to the subsequent economic
contraction. Liquid fuels include crude oil, lease condensate,
natural gas plant liquids, other liquids, and refinery processing
gains and losses as defined by the EIA. Source: Hirsch
(2010)

The combination of increasingly difficult-to-extract conventional
oil combined with depleting supergiant and giant oil fields, some
of which have been producing for seven decades, has led the
International Energy Agency (IEA) to declare in late 2010 that
the peak of conventional oil production occurred in 2006 (IEA,
2010). Conventional crude oil makes up the largest share of all
liquids commonly counted as “oil” and refers to
reservoirs that primarily allow oil to be recovered as a
free-flowing dark to light-coloured liquid (Speight, 2007).

The peak of conventional oil production is an important turning
point for the world energy system because many difficult
questions remain unanswered. For instance: how long will
conventional oil production stay on its current production
plateau? Can unconventional oil production make up for the
decline of conventional oil? What are the consequences to the
world economy when overall oil production declines, as it
eventually must? What are the steps businesses and governments
can take now to prepare?

In this paper we pay particular attention to oil for several
reasons. First, most alternative energy sources are not
replacements for oil. Many of these alternatives (wind, solar,
geothermal, etc.) produce electricity, not liquid fuel.
Consequently, the world transportation fleet is at high risk of
suffering from oil price shocks and oil shortages as conventional
oil production declines. Though substitute liquid fuel
production, like coal-to-liquids, will increase over the next two
or three decades, it is not clear that it can completely make up
for the decline of oil production.

Second, oil contributes the largest share to the total primary
energy supply, approximately 34%. Changes to its price and
availability will have worldwide impact especially because
alternative sources currently contribute so little to the world
energy system (IEA, 2010).

Last, oil is particularly important because of its unique role in
the global energy system and the global economy. Oil supplies
over 90% of the energy for world transportation (Sorrell et al.,
2009). Its energy density and portability have allowed many other
systems, from mineral extraction to deep-sea fishing (two sectors
particularly dependent on diesel fuel but sectors by no means
unique in their dependence on oil), to operate on a global scale.
Oil is also the lynchpin of the remainder of the energy system.
Without it, mining coal and uranium, drilling for natural gas and
even manufacturing and distributing alternative energy systems
like solar panels would be significantly more difficult and
expensive. Thus, oil could be considered an “enabling” resource.
That is, it enables us to obtain all the other resources required
to run our modern civilization.

2. The production perspective

It is commonly claimed that peak oil, i.e. the concept that oil
production will reach a maximum level then decline, is only about
geology. To some extent this is a result of the polarized debate
that has raged between geologists, such as Hubbert (1949; 1956)
or Campbell (1997; 2002), and economists, including Adelman
(1990) and Lynch (2002; 2003). In fact, peak oil is the result of
a complex set of forces that includes geology, reservoir physics,
economics, government policies and politics. However, a solid
understanding of the peaking and subsequent decline of oil
production begins with acknowledging the natural laws that create
a framework for everything. The intrinsic limitations of these
laws eventually affect all human activities because neither
economic incentives nor political will can bend or break these
laws of nature.

There are a number of physical depletion mechanisms that affect
oil production (Satter et al., 2008). Depletion-driven decline
occurs during the primary recovery phase when decreasing
reservoir pressure leads to reduced flow rates. Investment in
water injection, the secondary recovery phase, can maintain or
increase pressure but eventually increasingly more water and less
oil is recovered over time (i.e. increasing water cut).
Additional equipment and technology can be used to enhance oil
recovery in the tertiary recovery phase but it comes at a higher
price in terms of both invested capital and energy to maintain
production. The situation is similar to squeezing water out of a
soaked sponge. It is easy at first, but increasingly more effort
is required for diminishing returns. At some point, it is no
longer worth squeezing either the sponge or the oil basin and
production is abandoned.

Another way to explain peaking oil production is in terms of
predator-prey behavior, as Bardi and Lavacchi (2009) have done.
Their idea is that, initially, the extraction of “easy
oil” leads to increasing profit and investments in further
extraction capacity. Gradually the easiest (and typically the
largest) resources are depleted. Extraction costs in both energy
and monetary terms rise as production moves to lower quality
deposits. Eventually, investments cannot keep pace with these
rising costs, declining production from mature fields cannot be
overcome and total production begins to fall.

An additional factor plays an important role. In both models,
regardless of the abundance of capital or high prices, an oil
well is unable to deliver net energy at some point. Hubbert
(1982) wrote: “There is a different and more fundamental cost
that is independent of the monetary price. That is the energy
cost of exploration and production. So long as oil is used as a
source of energy, when the energy cost of recovering a barrel of
oil becomes greater than the energy content of the oil,
production will cease no matter what the monetary price may
be.”

These physical trends conspire to make oil production
increasingly difficult and expensive in monetary and energy
terms. Economic incentives and technological advancement can slow
these trends but they cannot be stopped.

2.1 Oil production today

Production peaks occur for many energy sources ranging from
firewood and whales to fossil fuels (Höök et al., 2010).
Currently, around 60 countries have passed “peak oil”
(Sorrell et al., 2009) — their point of maximum production. In
most cases this is due to physical depletion of the available
resources (e.g. USA, the UK, Norway, etc.) while in a few cases
socioeconomic factors limit production (e.g. Iraq).

Attempts to disprove peak oil that focus solely on the amount of
oil available in all its forms demonstrate a fundamental, and
unfortunately common confusion between how much oil remains
versus how quickly it can be produced. Although until recently,
oil appeared to be more economically available than ever before
(Watkins, 2006), others have shown this to be an artifact of
statistical reporting (Bentley et al., 2007). Further, it is far
less important how much oil is left if demand , for instance, is
90 Mb/d but only 80 Mb/d can be produced. Still, the most
realistic reserve estimates indicate a near-term resource-limited
production peak (Meng and Bentley, 2008; Owen et al., 2010).

Total oil production is comprised of conventional oil, which is
liquid crude that is easy and relatively cheap to pump, and
unconventional oil, which is expensive and often difficult to
produce. It is vital to understand that new oil is increasingly
coming from unconventional sources like polar, deep water and tar
sands. Almost all the oil left to us is in politically dangerous
or remote regions, is trapped in challenging geology or is not
even in liquid form.

Today, over 60% of the world production originates from a few
hundred giant fields. The number of giant oil field discoveries
peaked in the early 60s and has been dwindling since then (Höök
et al., 2009). This is similar to picking strawberries in a
field. We picked the biggest and best strawberries first (just
like big oil fields they are easier to find) and left the small
ones for later. Only 25 fields account for one quarter of global
production and 100 fields account for half of production. Just
500 fields account for two-thirds of all the production (Sorrell
et al., 2009a). As the IEA (2008) points out, it is far from
certain that the oil industry will be able to muster the capital
to tap enough of the remaining, low-return fields fast enough to
make up for the decline in production from current fields.

All oil sources are not equally easy to exploit. It takes far
less energy to pump oil from a reservoir still under natural
pressure than to recover the bitumen from tar sands and convert
it to synthetic crude. The energy obtained from an extraction
process divided by the energy expended during the process is the
Energy Return on Energy Invested (EROEI). It is a return on
investment calculation applied to a physical process. As Hubbert
noted, regardless of the price the market is willing to pay for
oil, just as we won’t spend a dollar to receive only a dollar in
return, when we expend as much oil as we get back from a
particular oil deposit, production will stop.

The EROEI of US domestic oil production (chiefly originating from
giant oil fields) has declined from 100:1 in 1930 to less than
20:1 for developments in the 2000s (e.g. Gulf of Mexico) (Gately,
2007; Hall et al., 2008; Murphy and Hall, 2010). Since giant and
super giant oil fields dominate current production, they are good
indicators for the point of peak production (Robelius, 2007; Höök
et al., 2009). There is now broad agreement among analysts that
the decline in existing production is between 4-8% annually (Höök
et al., 2009). In terms of capacity, this means that roughly a
new North Sea (~5 Mb/d) has to come on stream every year just to
keep the present output constant.

In 2010, the IEA (2010) abruptly announced that the peak of
conventional oil production was reached in 2006. The IEA
also again lowered their estimate of total world oil
production to less than 100 Mb/d by 2035. However, it
has been shown that the IEA oil production model is flawed.
To reach the production level in their model, they assume oil
field depletion rates that are so high that they have never
been seen in any oil region before (Aleklett et al., 2010).
The remaining oil simply cannot be produced as quickly as would
be required to push the production peak as far into the future as
they project, thus the peak must occur sooner than the IEA
asserts. Miller (2011) found that the IEA had not addressed any
of the recent critique and concluded that the IEA outlooks
likely remain too optimistic.

Most discussions about oil focus on the size of the resource
left. However, in the near term it is far more important to pay
attention to production flows and the constraints operating on
them. Peak oil is the point in time where production flows are
unable to increase. It is not just underinvestment, political
gamesmanship or remote locations that make oil production
increasingly difficult. The physical depletion mechanisms
(increasing water cut, falling reservoir pressure, etc.) will
unavoidably affect production by imposing restrictions and even
limitations on the future production of liquid crude oil. No
amount of technology or capital can overcome this fact.

3. The economic perspective

3.1 The economics of oil supply

One important feature of oil supply is its cyclical boom and bust
cycle in prices and production. Maugeri (2010, p. 12-13)
describes this phenomenon: “if petroleum becomes scarce and
there is no spare capacity...oil price climbs. This rise in
prices fosters a new cycle of investment from which new
production will flow. It also triggers gains in energy
efficiency, consumer frugality and the rise of alternative energy
resources. By the time the new production arrives at the market,
petroleum demand may have dropped. This vicious circle has been a
feature of all oil crises of the past.”

However, oil production recently became less responsive to
traditional economic stimuli. The first decade of this century
witnessed a dramatic increase in oil exploration and production
when the price of oil increased (Sorrell et al., 2009; 2009a).
Unfortunately, as noted already, total world oil production seems
to have reached a plateau nonetheless. To a large degree this is
because the oil that remains tends to be unconventional oil,
which is expensive and takes more time to bring to market. Some
consequences of having extracted much of the easy oil are the
following:

a) It takes significantly more time once a field is discovered to
start production. Maugeri (2010) estimates it now takes between 8
and 12 years for new projects to produce first oil. Difficult
development conditions can delay the start of production
considerably. In the case of Kashagan, the world’s largest oil
discovery in 30 years, production has been delayed by almost ten
years due to difficult environmental conditions.

b) In mature regions, an increased drilling effort usually
results in little increase in oil production because the largest
fields were found and produced first (Höök and Aleklett, 2008;
Höök et al., 2009).

c) Because the cost of extracting the remaining oil is much
higher than easy-to-extract OPEC or other conventional oil, if
the market price remains lower than the marginal cost for long
enough producers will cut production to avoid financial losses.
See Figure 3.

e) Most remaining oil reserves are in the hands of governments.
They tend to under-invest compared to private companies
(Deutsche
Bank, 2009).

f) Possible scarcity rents have to be taken into account.
Hotelling (1931) showed that in the case of an depletable
resource, price should exceed marginal cost even if the oil
market were perfectly competitive (the resulting difference
is called scarcity rent). If this were not the case, it
would be more profitable to leave the oil in the ground,
waiting to produce it until the price has risen. Hamilton
(2009a, 2009b) noted that while in the 1990s the
scarcity rent was negligible relative to costs of
extraction, the strong demand growth from developing
countries in the last decade together with limits to
expanding production “could in principle account for a
sudden shift to a regime in which the scarcity rent is
positive and quite important.” In this regard, the
Reuters news service reported on April 13, 2008 that
“Saudi Arabia’s King
Abdullah said he had ordered some new oil discoveries
left untapped to preserve oil wealth in the world’s top
exporter for future generations, the official Saudi
Press Agency (SPA) reported.” Therefore, a possible
intertemporal calculation considering scarcity rents may
have already influenced (i.e. limited) current
production. Although the sudden fall of prices at the end of
2008 is difficult to reconcile with scarcity rents, the
following quick price recovery to the 70$-120$ range during
the enduring global financial crisis indicates that
this aspect cannot be dismissed. This is despite the
assertion by Reynolds and Baek (2011) that the Hotelling
principle "... is not a powerful determinant of
nonrenewable resources prices," and
that"...the Hubbert curve and the theory
surrounding the Hubbert curve is an important determinant of
oil prices." We agree that the Hubbert curve, which defines
the depletion curve of a non-renewable resource, may be the prime
determinant of oil price but it is not the only one.

Figure 3. Global marginal cost of
production 2008. Source: LCM Research based on Booz Allen/IEA data
(Morse, 2009). The unlabeled items, from left to right are OPEC
Middle East, Former Soviet Union and Enhanced Oil
Recovery.

The consequence of these issues is that in the short-medium term
the available supply is essentially fixed and thus relatively
straightforward to compute. As Figure 4 shows, net production
capacity will decline due to the difficulty in finding new
reserves at an accessible cost while the existing capacity is
steadily depleted. Just as occurred in 2004, by 2011 there is
again no new net capacity while the world economy, and thus oil
demand, has resumed growth. After 2014, it appears that global
oil production will begin its decline (See the second report of
the UK Industry Taskforce
on Peak Oil and Energy Security (UK ITPOES, 2010), Lloyd’s
(2010), Deutsche Bank (2009, 2010), the report by the UK Energy
Research Centre (Sorrell et al., 2009a) and the 2010 World Energy
Outlook by the IEA (2010).)

3.2 The economics of oil demand

An important question now is what are the consequences of high
oil prices on world economic growth? In the economic literature
Hamilton (2009b) and Kilian (2008; 2009) attempt an answer, while
in the professional financial literature the report by Deutsche
Bank (2009) is one of the most comprehensive.

Hamilton (2009b) in particular highlighted the importance of the
share of energy expenditure as a percentage of total consumer
expenditure. When this ratio is too high an economic recession
tends to occur. Similarly Deutsche Bank (2009) showed how each
country seems to have a “threshold percentage of national
income at which crude pricing meets stern resistance and demand
is broken.” Deutsche Bank (2009) asserts that for American
consumers this point is when energy represents 7.5% of gross
domestic product. This value is close to the one calculated by
Hamilton (2009b) but is based on monthly data and uses a
different methodology. In a more recent report, Deutsche Bank
(2010) lowered this threshold to 6.5 % because "...the last
shock set in motion major behavioral and policy changes that will
facilitate rapid behavioral changes when the next one comes and
underemployment and weak wage growth has increased sensitivity to
gasoline prices. Last time it took $4.50/gal gasoline to finally
tip demand, this time it might only take $3.75/gal to $4.00/gal
to do it." However, they also highlighted that
"Americans have become comfortable with paying more for
gasoline, and it may take higher prices to force behavior
change".

Kopits (2009) suggested that when crude oil expenditures exceed
4% of GDP, oil prices increase by more than 50% year-on-year, and
oil price increases are so great that a potential demand
adjustment should have to reach 0.8% of GDP on an annual basis,
then a recession in the US is very likely. A similar outcome was
found by Hall et al. (2009) who showed a recession in the US is
likely when oil amounts to more than 5.5% of GDP. We remark that
the difference between the 4% (Kopits, 2009) and 5.5% (Hall et
al., 2009) is simply a wholesale versus retail difference, and
the result comes out the same [1].

Finally, Hamilton (2011) highlighted that 11 of the 12 U.S.
Recessions since World War II were preceded by an increase in oil
prices. Unfortunately, there is no clear alternative source of
energy able to fully substitute for oil (see, for example,
Maugeri (2010) for a recent non-technical review of the limits of
alternative sources of energy with respect to oil). It possesses
a combination of energy density, portability and historically
very high EROEI that is difficult for alternatives to match.

4. A timely energy system transformation not
assured

As oil production declines, significant changes to the currently
oil-dependent economy in the medium term are likely to be needed.
However, it isn’t clear that there will the financial means to
implement such a change. For example, Deutsche Bank (2009, 2010)
suggested that the widespread use of electric cars in the second
part of this decade will be the disruptive technology that will
finally destroy oil demand. Apart from technology and resource
constraints (lithium necessary for electrical batteries is quite
abundant in nature but production is currently very limited), the
availability of sufficient financial resources to transition the
entire vehicle fleet seems dubious. As Hamilton (2009b)
demonstrates, tightened credit follows high oil prices and most
vehicles are purchased on credit. Others suggest that natural gas
is the next energy paradigm. Again, will be there sufficient
financial resources to switch to it as oil production declines?

Reinhart and Rogoff (2009, 2010) found that historically, after a
banking crisis, the government debt on average almost doubles
(86% increase) to bail out the banks and to stimulate the
economy. They also showed that a sovereign debt crisis usually
follows: not surprisingly we saw Iceland, Greece, Ireland,
Hungary and Portugal turning to the EU/ECB and/or the IMF for
financial help to refinance their public debts to avoid default.
The need to switch to alternative energy sources with the
enormous financial investments that such a task would require —
and the simultaneous presence of large public and private debts —
may well form a perfect storm.

Figure 5. Public debt as a percent of GDP
(2009/2010) taken from CIA Factbook (2010).

Additional forces will play a role. New regulations to be
introduced by Basel III are likely to impact investment
expectations, budgeting and planning. Basel III is a new
global regulatory standard on bank capital adequacy and liquidity
proposed by the Basel Committee on Banking Supervision following
the recent global financial crisis and whose aim is
to "...to improve the banking sector's ability to absorb
shocks arising from financial and economic stress, whatever the
source, thus reducing the risk of spillover from the financial
sector to the real economy", BCBS (2009). Demography will
also be extremely important in the next decade as well. Europe
and the United States have aging populations and their baby
boomers are entering pension age. China faces a similar
demographic problem due to their one child policy, too.

The combination of declining oil production (and thus oil priced
high enough to cause recessions), high taxes, austerity measures,
more restrictive credit conditions and demographic shifts have
the potential to severely constrain the financial resources
needed to move the economy away from oil and to alternative
energy sources. Another consequence of this combination of forces
is the likely contraction of the world economy (Hamilton, 2009b;
Dargay and Gately, 2010).

4.1 Energy transition risks

With higher priced oil, technology substitution (such as electric
cars gradually replacing internal combustion engine cars) and
fuel substitution (such as natural gas replacing oil) will occur.
History is filled with many such examples and they are frequently
highlighted in the debate. However, one must read carefully and
not overstate the simplicity of an energy transition.

For example, whale oil was – technically – an energy source in
the 19th century, but the economy was based on coal at the time.
Whale oil was used only for very specific purposes (primarily
illumination), and the transition to kerosene was easy and
occurred very rapidly. Bardi (2007) explored this in more
detail and made several important remarks that pinpoint how
difficult it can be to substitute energy
sources. In particular, he showed that resource
scarcity often dramatically increases the amplitude of price
oscillations, which often slow an energy source transition.
Businesses and governments struggle with alternating
circumstances of insufficient cash flow to handle price spikes
and plummeting prices that don't cover their cost structure. Long
term planning in this ever-changing environment becomes extremely
difficult and investment — even highly needed investment — can
drop precipitously.

Friedrichs (2010) also cautions that after peak oil countries
have several sociological trajectories available to them: they
can follow predatory militarism like Japan before WWII,
totalitarian retrenchment like North Korea, or, ideally,
socioeconomic adaptation like Cuba after the fall of the Soviet
Union. Given the recent century of conflict and the extensive
weapon stocks and militaries held by modern nations (especially
the United States, which spends on its military almost as much as
the remaining countries of the world combined (SIPRI, 2011),
there is simply no guarantee that the relatively peaceful period
currently experienced by developed nations that is conducive to
rapid energy source transitions will continue much longer.

Koetse et al. (2008) showed that for both North America and
Europe the capital-energy substitutability over the long term is
large. In other words, if there is abundant capital, the economy
can respond to higher oil prices with substitution. However, if
declining oil causes a credit contraction similar to the crash of
2008, there may not be sufficient capital to replace existing
equipment quickly.

Even if there is sufficient capital, substitution has thus far
operated with high and even increasing EROEI fuel sources. Since
the transition from whale oil, each subsequent transition has
been to an energy source with greater net energy profit. The
energy dense fuels we are using now have allowed us to build our
civilization. The difficulty this time is that we must move from
highly profitable, in terms of energy, sources to lower profit
alternatives like solar and wind. Researchers are beginning to
ask the following important question: what is the minimum energy
profit that must be sustained to allow us to operate our
civilization? And, assuming alternatives are up to the job (this
is not yet proven), can we complete the move away from oil before
the overall EROEI gets too low? (Murphy and Hall, 2010)

A further challenge is that, strictly speaking, for the last 150
years we have not transitioned from previous fuel sources to new
ones — we have been adding them to the total supply. We are
currently using all significant sources (coal, oil, gas and
uranium) at high rates. Thus, it’s common but incorrect to say
that we moved from coal to oil. In fact, we are using more coal
now than we ever have (IEA, 2010). We never left the coal age.
The challenge of moving to alternative energy sources while a
particularly important source is declining, in this case oil,
should not be underestimated.

4.2 Net oil exports decline faster than overall production

The challenge may be greater still because net oil exports are
set to fall more rapidly than overall oil production. Rubin
(2007) points out that before the financial crisis many producer
countries were experiencing economic booms. These countries
export only the oil they don’t use themselves. The Middle East
saw annual consumption increases of 5%. Russia was increasing at
a 4% annual rate. It was only Russia’s increased production
during the same period (accounting for 70% of the increase that
came from OPEC, Russian and Mexican production during the early
part of the last decade) that oil prices did not break records
sooner than they did. Although the IEA has projected that oil use
in OECD countries may already be declining (IEA 2010), they think
that the oil appetite of non-OECD countries, which includes the
producer countries, is not even close to being satisfied.

Brown et al. (2010b) show how significant the squeeze of
declining gross production and increasing producer country
consumption can be, which they have named the Export Land Model.
Increasing producer country consumption due to population growth
acts as a strong “magnification factor” that removes oil
very quickly from the export market. Using the top five exporting
countries from 2005 (Saudi Arabia, Russia, Norway, Iran and
United Arab Emirates), they construct a scenario in which
combined production declines at a very slight 0.5% per year over
a ten year period for a total of 5%. Internal oil consumption for
these exporters continues to grow at its current rate (2010). In
this scenario net oil exports decline by 9.6%, almost double the
rate oil production declines.

Figure 6. Crude oil production,
consumption and exports for Indonesia (left) and Egypt (right).
Steadily increasing internal consumption coupled with a 1/3 drop in
domestic production turned Indonesia into a net oil importer just
12 years after its peak of production. Egypt has lost all it oil
export revenue and will soon follow Indonesia to become a net oil
importer. Source: BP Statistical
Review (2010).

This accelerated loss of exportable oil can be seen in many
producer countries that have passed their peak. Figure 6 shows
the typical cases of Indonesia and Egypt. Indonesia has withdrawn
from OPEC because they have no more exportable oil to offer the
world market. Egypt is already incurring a public debt and is on
the cusp of becoming a net oil importer, which will exacerbate
already stretched public finances. As producer countries continue
to grow their oil use even modestly and production declines
(again, even modestly), there is an extremely high risk that net
exportable oil will decline much faster than most observers are
currently expecting.

4.3 Crash program may eventually replace declining oil

Hirsch (2010) points out that a crash program to create liquid
fuel savings and additional liquid fuels may be able to, at some
point, make up for declining oil production (Figure 7). While the
alternatives are ramping up and as oil production is declining,
Hirsch (2008) estimates that the world economy will contract at
approximately a one-to-one ratio. In his best-case scenario,
using a 4% per year decline rate, an idealized crash program to
produce liquid fuels does not pause contraction sooner than ten
years after the onset of decline.

Figure 7. Liquid fuel mitigation programs
take at least ten years before they are able to make up for
declining oil production. Source: Hirsch (2010)

Other mitigation efforts like increased solar, wind and
geothermal production may not be prioritized since they do not
help the situation — they produce electricity and the
world’s 800 million transportation, food production (i.e.
tractors and harvesters) and distribution vehicles require liquid
fuel.

If the peak of oil production occurs this decade, there is
insufficient time to avoid contraction because of how long it
takes to transition the vehicle fleet. Even in their moderately
aggressive scenario, Belzowski and McManus (2010) estimate that
in a healthy, growing economy by 2050 still only 80% of the
vehicle fleet in Europe and the U.S. would operate on alternative
power trains.

5. Government risks

A contracting economy presents governments with a host of
problems that are not easy to resolve. Promises made to the
citizenry, some in the form of social welfare programs, pensions
and public union contracts, will be impossible to keep as the
energy base of the economy declines. Downward wage pressure and
reduced business activity will lower tax revenue. With lower
revenues and greater demands in the form of social welfare
support by an increasingly poorer citizenry, it is difficult to
see how the accumulated (and growing) government debt can be paid
back without rampant inflation. Though it is still unclear
whether the government response will be hyperinflation (to
minimize the debts) or extensive and massive debt defaults — or
both — it is not likely that business as usual will continue as
oil production declines.

In business sectors that are highly dependent on oil, such as the
automotive sector (Cameron and Schnusenberg, 2009), ill prepared
companies that lack understanding of how price volatility may
impact their firm will likely fail. In the case of the car
companies some may fail a second time because their products are
still not yet ready for a high-priced oil environment (Wei et
al., 2010). Governments may not be willing to spend the money to
rescue these businesses (such as the car company bailouts in the
U.S.) and should be prepared for increasing unemployment as
vulnerable sectors contract. To minimize potential future social
discord, governments should immediately begin planning for
contraction and educating their citizenry of the risk of
contraction.

Because poverty reduction is highly correlated with capital
availability (World
Bank 2001), as contraction occurs due to oil production
decline some countries may see the reversal of poverty reduction
gains made in recent decades. Some governments may also have to
contend with food and fuel riots as they did in 2007 and 2008.
Other forms of crowd behavior, namely hoarding of fuel and food,
may exacerbate the situation and governments should prepare
accordingly.

6. Business risks

In a joint report, Lloyd’s of London and Chatham House have
advised all businesses to begin scenario-planning exercises for
the oil price spike they assert is coming in the medium term
(Lloyd’s, 2010). These planning exercises should scrutinize a
company’s operations and balance sheet in fundamental ways.

Like governments, businesses of all sorts may experience similar
difficulty paying their debts as sales decline. Banks may see
asset values fall further. Manufacturers in particular will have
to contend with increased difficulties making and delivering
products as oil production declines (Hirsch et al., 2005). It
will prove imperative that business addresses this Schumpetarian
shock (a structural change to industry that can alter what is
strategically relevant) in a timely fashion (Barney, 1991).

A significant benefit of cheap oil was that distance was
relatively inexpensive. It is possible now to manufacture goods
using far-flung operations. However, as oil declines, distance
will, once again, become increasingly expensive, and oil price
may begin to act as a trade barrier for many products.

Another risk as oil production declines is the possibility of oil
supply disruptions. If this should occur, much modern
manufacturing may be impacted. Just-in-time manufacturing systems
in which warehoused parts are minimized through the frequent
replenishment of parts by parts suppliers — sometimes with
multiple deliveries a day — have little tolerance for delivery
delays.

To prepare for this risk requires more than the drive for
manufacturing efficiency that has generally characterized
business. Supply chains should be examined with the aim of
building in resilience and greater agility (Bunce and Gould,
1996; Krishnamurthy and Yauch, 2007), implying the loosening of
tight and often brittle couplings between suppliers and
manufacturers (Christopher and Towill, 2000; Towill and
Christopher, 2001). With little or no slack in the system (fewer
warehoused parts, etc.), just one supplier failing to deliver a
part or supplier hoarding can shut down a production process.

7. Conclusion

The Deepwater Horizon incident demonstrated that most of the oil
left is deep offshore or in other difficult to reach locations.
Moreover, obtaining the oil remaining in currently producing
reservoirs requires additional equipment and technology that
comes at a higher price in both capital and energy. In this
regard, we reviewed the physical perspective of peak oil and some
of the limitations on producing ever-increasing quantities of oil
were highlighted as well as the possibility of the peak of
production occurring this decade.

We then briefly discussed the economics of oil supply and demand,
showing why the available supply is basically fixed in the
short-medium term and highlighting the importance of a high
energy expenditure share as a percentage of total consumer
expenditures as an alarm bell for economic recessions. Moreover,
we remarked that the potential financial resources that can be
available in the future to switch to alternative sources of
energy will be limited due to several factors ranging from the
high levels of debt (both private and public) to the ageing of
the populations in Western countries and China. We also noted
that, even with very slight production decline rates, net oil
exports decline significantly faster than total oil production as
the economies of producer countries grow.

In such a context, risk mitigation practices are called for, both
at the government level and at the business level to prepare for
high and likely volatile oil prices. Governments should begin
educating their citizenry of the risk of contraction to minimize
potential future social discord. Businesses should examine their
operations and balance sheets with the aim of building in
resilience. It also implies preparing for a scenario in which
capital and energy are much more expensive than in the
business-as-usual one.